Sunday, February 15, 2015

The harsh realities of the Greece-Eurozone game of chicken

Posted by Walter

The Greece-Eurozone dispute has received a great deal of attention in the media in recent weeks. It seems however that contradicting statements and polarized views - many tainted by various political agendas - have created a great deal of confusion around the subject. As the parties resume negotiations this coming week, lets look at what each has to lose if a solution is not reached in time.

The damage to the euro area

First of all it's important to point out that the so-called "Grexit" is equivalent to a complete failure to pay on obligations by the Greek government, its banks, corporations, and households. While everyone is focused on the €315 billion Greece owes to the Eurozone, the IMF, and others, the damage to the euro area would actually be much greater.

Source: Bloomberg

What nobody wants to talk about is the fact that internally most Greek loans - including mortgages - are in euros (some are even in Swiss francs). Greek banks hold €227 billion of loans and €12.4 billion of Greek government debt (plus roughly another €25 - €50 billion of Greek-based private sector bonds). Under a Grexit scenario, most debt (including government debt) will be converted to the new drachma at a preset exchange rate.

As the drachma collapses - and there is little question that it will - Greek banks, who would now have drachma assets and euro liabilities, will quickly fail as well, leaving the Bank of Greece holding the bag. The Bank of Greece which is currently part of the Eurosystem will therefore default upon exit. But before it exits, the Bank of Greece will draw on Target2 from the rest of the Eurosystem as Greeks quickly move their deposits out (see how the mechanism works here with the Bank of Spain example). And there is no question Greeks will try to move a great deal of their deposits out before they are converted to drachmas. In December alone they pulled €4.6 billion euros out of Greek banks - and that's before the Syriza victory.

The default by the Bank of Greece could cause even more damage to the system than the losses to EFSF and to other entities such as the IMF. Between the government bonds the Eurosystem holds and the Target2 losses, the ECB may need to be recapitalized - a political disaster. Market anxiety alone could push the euro area back into recession as credit conditions tighten again (potentially similar to the Lehman situation).

In the long run, if Grexit becomes a reality, the whole EMU could become unstable. History certainly isn't on the euro area's side.

Source: @RBS_Economics

Of course the Greek membership in NATO and the nation's ports on the eastern Mediterranean that are strategically important to the West could be in jeopardy as well. In particular, Greece's recent interest in establishing a stronger relationship with Russia (see story) is scaring a number of NATO generals.

The damage to Greece

Greece is quickly running out of time. And it's not just the debt maturity wall in 2015.

Source: @Eurofaultlines

We are talking about hitting the wall at the end of this month. Greek citizens are in the street these days with a new slogan "Bankrupt but Free". Of course it's all fun and games until pensioners line up at the soup kitchens and move into the homeless shelters because they can't get their retirement checks. It's a matter of weeks before Greek government employees no longer get their payments. Why is the situation so dire all of a sudden? Part of the problem is that the tax revenue is falling sharply now.

WSJ: - Government income has declined sharply in recent weeks as many Greeks have stopped paying taxes in hope that the country’s new, leftist government would cut taxes. Tax revenue dropped 7%, or about €1.5 billion euros, in December from the previous month and likely fell by a similar percentage in January, according to Economy Minister George Stathakis.

“We will have liquidity problems in March if taxes don’t improve,” Mr. Stathakis said.

Other officials warned the country would have difficulty paying pensions and other obligations beyond February.

And if the new government thinks their tax collection abilities will improve after Grexit, they are kidding themselves.

Furthermore, in the face of such uncertainty, Greek businesses will demand bags of drachmas for any goods and services they offer. And there is little chance that foreigners will accept drachmas for shipments of food, fuel, etc. With Greek government euro accounts frozen abroad after the default, access to hard currency will be cut off as the Bank of Greece will be forced to sell off its gold holdings. It's a humanitarian crisis in the making.

The compromise

Given such enormous risks to both parties a compromise will probably be reached. A bridge loan of some kind is likely in the nearterm. Beyond that we have some great unknowns and multiple rounds of "game of chicken" between the two parties.

One can sit around and pass the blame (see post) for the situation in which these parties find themselves today. But these are the harsh realities we are faced with and a longer term solution that softens the fiscal constraints on Greece while changing its liability structure will need to take shape. Otherwise the story of the European Monetary Union will enter its darkest chapter yet.